Adjustable Rate Mortgage Pros and Cons
Adjustable rate mortgage, otherwise known as ARM are home loans which begin with a low fixed interest rate for three to ten years followed by regular changes on the rate. The changes are according to an interest index like the London Interbank Offered Rate (LIBOR). Usually, the interest rate alters upwards because there is a margin added to the current rates. The ARM is appropriate for particular situations though it might lead to foreclosure in other cases. It is, therefore, useful to understand their features and to consider the long term problems and short term rewards this loan option has to give.
How do adjustable rate mortgage works?
With an adjustable rate mortgage, payments may decrease or increase according to the interest change, according to the terms of the loan and a benchmark interest rate index selected by the financier. Some of the time, opting for the adjustable rate mortgage over the fixed rate mortgage may be an excellent financial alternative which saves the borrower a lot of money. The borrower should always be aware of the immediate risks and exactly how much the payments can increase. Several people believe fixed rate mortgages are the better options. However, ARMs may be an alternative for the home buyers that know they will have the loan for only a few years. The ARMS may be optimal for those clients who know they are relocating within the near future or they are sure they will be able to pay off the loan within a few years may be due to the maturation of trust funds or an inheritance.
Fixed Interest Rate Period
The most common adjustable rate mortgage is known as a hybrid ARM. Here, a specific interest rate is meant to remain set for a particular amount of time. Most often, the initial rate would be lower compared to what the borrower could get within a 30 year fixed loan. A 3/1 or 5/1 ARM is going to give a fixed interest rate for three to five years, respectively.
On the other hand, the fixed period may vary significantly from one month up to ten years, and it is only going to be limited by what the lender allows. Usually, a shorter fixed time means a lower interest rate during that period. For those individuals that refinance the mortgage or relocate every couple of years, the ARM would be a great way to pay less in interest that would have been possible with a standard 30-year loan. At the same time, the fixed period may provide time to assess the direction the interest rates are heading and make a decision on when to refinance on loan. Several people opt for refinancing near the end of the fixed rate period.
How the adjustable Fixed Rate Mortgages are calculated
The approach for calculating interest rates on the adjustable mortgages is set from the following equation.
Index rate + margin = interest rate
The index rate is based on three indexes which are the one year Treasury Bill, the London Interbank Offered Rate or LIBOR or the Cost of Funds Index, otherwise known as the COFI. Some lenders have their cost of funds index meaning it is crucial to question the index used and where it would be published to keep track of it. The lender opts for the index to base the rate on when applying for the loan even though the LIBOR is the most popular index utilized. The lender also determines the margin to be paid and the number of percentage points to be added to the index. The margin percentage depends from one lender to the next, and it should be one of the focal points of the research when applying for the ARM. This margin should be constant throughout the lifespan of the loan.
Types of ARMs
The hybrid ARM is not the only variation. If misunderstood, the following ARMs can have severe effects on financial circumstances and credit of the borrower.
In this case, the borrower only pays the interest for a particular time after which they would begin to pay both the principal and the interest. The interest-only period is towards the beginning between the first three and ten years. It will just during the interest only time and the interest + principal payment period. The former payment period is significantly less of course than when the borrower starts paying on the principal and the interest.
Introductory period ARM
This is about how long the initial rate would remain the same before adjustments are made on the financial institution. It may be a 3 or 5-year introductory period.
Payment option ARM
This ARM approach would allow one to choose between the alternatives every month. The borrower might want to make traditional principal and interest infusions or only interest payments. They may only make a limited fee less than the interest due that particular month.
Pros and Cons of ARMs
Advantages and disadvantages of ARM include the following:
- Ability to afford a larger mortgage amount: the lower interest rate and regular monthly payment allow borrowers to be able to get a larger loan amount compared to a fixed rate mortgage.
- Lower fixed interest: in the event the ARM has a period with a fixed interest rate; it would be lower than the rate on a permanently fixed interest rate mortgage.
- It helps if one has a more prominent home: the initial payment is usually smaller than the loan using a permanently fixed rate and so ARM would allow the borrower to qualify easier for a larger loan.
- Interest rates might rise: within a hybrid ARM, the interest rate during the fixed period is often low. However, the payments may still rise high when the interest rate resets.
- It is possible to forgo low fixed interest rate: even though the interest rate on the ARM I lower than that of a 30 year fixed mortgage, it is going to reset, and the rates could increase before the borrower refinances.